Final Exam Macroeconomics Winter 2011 Prof. Veronica Guerrieri

Transcription

1 Final Exam Macroeconomics Winter 2011 Prof. Veronica Guerrieri Name (print): Name (signature): Section Registered (circle one): T 1:30 T 6:00 W 1:30 As always, the honor code rules are in effect. You know the routine. All the usual disclaimers apply. By signing above, you are pledging to adhere to the honor code guidelines in my syllabus and the student handbook. This implies that you are not allowed to discuss test questions with anyone until after the answers are posted. Remember, some of your classmates will not take the exam until March 16th. You have 3 hours for the exam. This should not be a constraint. Unless otherwise indicated, assume all curves are well behaved (i.e., labor supply slopes up, labor demand slopes down, IS slopes down, etc). For discussion problems, explain - but do not be wordy! (The more you say, the more likely you will say something wrong). Please, read carefully the directions and the assumptions that I make for each question. Sometimes the assumptions make a difference for the answer. You are allowed: Two pieces of paper, both sides Handwritten or Typed (minimum 12 fonts, no fotocopies) A calculator Good Luck! 1

2 Exam Assumptions The following assumptions hold throughout the entire exam, unless told otherwise: 1) we always start at Y*, 2) the short run aggregate supply curve is upward sloping (version 2 of SRAS), 3) all variables (consumption, investment, etc.) are real variables, 4) capital is fixed in both the short and long run, but it is allowed to change in the really long run (when we think about growth), 5) NX = 0, unless otherwise indicated, 6) no policy response takes place if I do not specifically say so. NOTICE: All your answers should be cast in terms of the model we have developed! 2

3 Question 1 Given what we learned in class, which of the following statements are true and which false? No explanation needed. (2 points each 16 points total) a. If realized inflation is lower than expected, borrowers end up better off than expected. b. According to the Solow model, a one-time increase in productivity (TFP) generates higher consumption both in the short run and in the long run. c. According to the theory of consumption we have seen in class, a tax cut should have bigger effects on the consumption of liquidity constrained households than on unconstrained ones. d. Everything else constant, an increase in government spending that affects the country s TFP is necessarily associated to an increase in structural deficit. e. Countries with more independent central banks tend to have higher inflation. f. According to the real business cycle theory, business cycle fluctuations are mainly driven by fluctuations in TFP. 3

4 g. Imagine the economy starts at potential Y*. In response to a negative shock to demand, e.g. consumer confidence loss, output drops more in the short run if all prices are sticky (version 1 of the SRAS) than if only nominal wages are sticky (version 2 of the SRAS). h. If a country runs a trade surplus and net factor payments are zero (that is, NX > 0 and NFP = 0), the country must be a net lender to the rest of the world (that is, the country s net investment in foreign financial assets must exceed foreign countries net investment in domestic assets). 4

5 Question 2 Given what we learned in class, explain why each of the following statement is true, false, or ambiguous. The explanation makes your grade. I will give no credit for writing true when the answer is true but your logic is wrong. Be short! (4 points each 16 total) Base your answer on the models seen in class. a. According to the misperception theory, monetary policy is non-neutral only if it is expected. (4 points) b. During the Great Depression, real money supply declined dramatically because the Fed reduced the monetary base of the economy. (4 points) 5

6 c. One possible story behind the financial distress of the banking system in the recent crisis is that banks did not predict the nation-wide bust in house prices. (4 points) d. Recently, there has been a lot of debate about the effectiveness of the fiscal stimulus that has been implemented by the US government. According to Keynesian economists, the fiscal multiplier is bigger than one. (4 points) 6

7 Question 3 Consider a PIH agent, Veronica, who lives two periods. Assume that r =0 and Veronica has the same preferences seen in class with logarithmic utility and β=1, so that that she wants exactly the same consumption in the two periods. Imagine that she has an income equal to 8 in the first period and 8 in the second period. Also assume that she starts her life with wealth a=0. (8 points total) a) What is Veronica s consumption/saving plan? 2 points C S Period 1 Period 2 b) Now imagine that at the beginning of the first period the economy enters a recession and Veronica s income in period 1 drops to 4. What is then her new consumption/saving plan? What is her marginal propensity to consume? 3 points C S Period 2 Period 3 c) Finally, imagine that Veronica loses her confidence in a quick recovery and she expects the recession to last longer. So, she expects also her income in period 2 to drop to 4. What is now her consumption/saving plan? What is her marginal propensity to consume? 3 points C S Period 2 Period 3 7

8 Question 4 Answer briefly the following questions (4 points each 12 points total). a. Why is the IS curve downward sloping in a closed economy? (4 points) b. Why is the IS curve downward sloping in an open economy? (4 points) c. What does it mean that a country is in a liquidity trap? (4 points) 8

9 Question 5 Ireland was the fastest growing OECD economy since the mid-1990s. A report of the OECD claims that this pace of growth is virtually unprecedented in the experience of OECD countries. Ireland looked and felt like a different place from the one economists had taken to describe as the sick man of Europe in the 1980s. Indeed, with the economy developing at a speed more familiar to emerging countries, Ireland was now dubbed the Celtic Tiger. Using our model, we can represent what happened in Ireland in the 90s as a permanent increase in productivity (A) that shifted the potential level of output of the economy from Y* to Y** > Y*. (16 points total) Assumptions throughout the exercise: Use version 2 of the SRAS. Also, if there is a change in PVLR, ignore the income effect on the labor supply curve (suppose it is so small that you can ignore it). a. Represent graphically and describe in words what happens in the labor market in the long run if Ireland is hit by a permanent increase in A. What happens in the long run to N and to the real wage? (4 points) N S W 0 /P 0 (a) N* N N d 9

10 b. Imagine that we start at Y = Y* (initial potential of the economy) and the economy is hit by an increase in A. Assume that the shift of the AD curve is much smaller than the shift of the SRAS, so that prices decrease in the short run. Represent graphically what happens in the short run both in the AD-AS and in the IS-LM model. What happens in the SHORT RUN to Y, P and r? Explain why the curves move. (4 points) Y P r LRAS SRAS LM P 0 r 0 AD IS Y* Y* 10

11 c. Assume that output in the short run is below the new potential (Y 1 < Y**). Represent graphically what happens in the short run in the labor market. What happens in the short run to N and w/p in comparison to the initial state of the economy? Why? What happens to unemployment? (4 points) N S W 0 /P 0 (a) N* N N d 11

12 d. Let the economy react by itself, without introducing any further intervention. Represent graphically what happens in the long run with both the AD-AS and the IS-LM model. Remember that we assumed that output in the short run is below the new potential. What happens in the LONG RUN to Y, P and r in comparison to the original situation? Explain why the curves move. (4 points) Y P r LRAS SRAS LM P 0 r 0 AD IS Y* Y* 12

13 Question 6 Ireland was deeply hit by the global financial crisis in 2007, as many private banks were exposed to real estate risk. This generated a big banking crisis that spurred a deep recession. In this (and in the following) question, we analyze the experience of Ireland through the lens of our model. (20 points total + 4 extra) Assumptions throughout the exercise: Use version 2 of the SRAS. Also, if there is a change in PVLR, ignore the income effect on the labor supply curve (suppose it is so small that you can ignore it). PART I. Assume we can represent the Irish recession as driven by a negative demand shock generated by the financial crisis. That is, assume that both consumption and investment dropped because of a rationing in credit to households and businesses and of a loss of confidence (lower expected TFP and PVLR). Assume that A does not change. a. Imagine that we start at Y = Y* (potential output) and the economy is hit by a reduction in I and C due to the financial crisis, as explained above. Consider our IS-LM and AD-SRAS framework. What happens in the short run to output, prices and interest rate? Which curves move in the short run and why? (4 points) Y P r LRAS SRAS LM P 0 r 0 AD IS Y* Y* 13

14 b. Represent graphically what happens in the short run in the labor market. What happens in the short run to N and w/p? Why? (4 points) N S W 0 /P 0 (a) N* N N d 14

15 PART II. Consider now the effects of the financial crises on private banks decisions and the money market. Banks realize that the value of their assets dropped and are afraid to become insolvent so increase their desired reserve/deposit ratio. Let us analyze the additional effects coming from this channel, if the central bank does not change the monetary base in the economy. c. Explain how an increase in the desired reserve/deposit ratio of private banks affects the money market, taking prices as given. What happens to M/P and to the interest rate? (4 points) d. Starting from the short run equilibrium that you derived in point (a), represent graphically the additional effects due to an increase in the reserve/deposit ratio of private banks. What happens to output, prices and interest rate in comparison to the short run equilibrium derived in point (a)? Explain which curves will move and why. (4 points) Y P r LRAS SRAS LM P 0 r 0 AD IS Y* Y* 15

16 PART III. Imagine that the Irish central bank could conduct monetary policy independently from the rest of Europe. Let us analyze what would be the effects of an aggressive monetary expansion. e. Start from the short run equilibrium that you derived in point (d) and represent graphically an expansionary monetary policy strong enough to bring output back to potential. What happens to output, prices and interest rate in comparison to the short run equilibrium derived in question (d)? Explain which curves will move and why. (4 points) Y P r LRAS SRAS LM P 0 r 0 AD IS Y* Y* 16

17 f. BONUS QUESTION (4 extra points) Do you think that if Ireland was outside the Euro area and could conduct independent monetary policy, this could have been enough to recover and go back to potential (Y*)? Can you think of one reason why the monetary policy could have not been very effective, given that Ireland was in a financial crisis? (HINT: think about the slope of the curves) (4 points) 17

18 Question 7 Given the depth of the recession, the Irish government decided to bail out the main Irish private banks, generating a huge fiscal deficit that increased Debt/GDP. Investors started to worry and Ireland entered a sovereign debt crisis. (16 points total + 4 extra) Assumptions throughout the exercise: Use version 2 of the SRAS. Part I. As we discussed in class, a bailout is typically accounted NOT as an increase in G, BUT as an increase in the transfers of the government to private agents (banks in this case). Assume the bailout is successful and an increase in transfers to private banks help them to get out from their financial distress, reduce the reserve/deposit ratio back to its pre-crisis level and give credit to households and businesses as in the past. That is, assume we can represent a bailout in our economy, as an increase in I and C that bring output back to potential. Assume that A did not change. a. Imagine that at time 0 Ireland is in a recession driven by a demand shock (that is, Y 0 < Y*), as depicted in the graphs below. Consider the effects of a bailout (an increase in I and C as described above) big enough to bring output back to potential Y*. Assume that it does not affect A. Use the IS-LM and AD-AS framework. What happens to output, prices and interest rate? Which curves move in reaction to the bailout and why? (4 points) Y P r SRAS LM P 0 r 0 AD IS Y 0 Y* Y 0 Y* 18

19 b. When the financial crisis hits, Ireland had a low debt/gdp ratio (approximately equal to 20%) and a growth rate of real GDP much higher than the interest rate on Irish government bonds (that is, r < ΔGDP/GDP). Given that taxes and transfers are automatic stabilizers, what is the effect of the recession on the Irish government s primary deficit and on the change in Debt/GDP? What is the direct effect of the bailout on the Irish government s primary deficit and on the change in Debt/GDP? (4 points) Part II. Now assume that people start to worry about the expected increase in debt/gdp and become afraid that Ireland may decide to default on its debt. That is, government bonds bear a big risk premium. We can represent this in our model, as an increase (shift up) in money demand (= decrease in demand for government bonds), everything else equal. That is, if government bonds become more risky, suddenly people prefer to keep a bigger fraction of their wealth in money! c. Assume that households are worried about the Irish government to default and increase their money demand, everything else equal. How this affects the money market? What happens to M/P and to the interest rate, if prices are given? How can the change in the interest rate feedback on the evolution of debt/gdp? (4 points) 19

20 d. Start from the equilibrium you derived in question (a) after the bailout. Consider the additional short-run effects coming from the increase in the risk associated to government bonds (increase in money demand). Use the IS-LM and AD-AS framework. What happens in the short run to output, prices and interest rate relative to what would have happened without taking into consideration the effect of the default risk, that is, relative to the equilibrium derived in question (a)? Which curves move in the short run and why? (4 points) Y P r SRAS LM P 0 r 0 AD IS Y 0 Y* Y 0 Y* 20

21 e. BONUS QUESTION (4 extra points) The fact that international investors do now want to invest in Irish bonds (even though the interest rates are very high) because of the big default risk, makes capital flow out from Ireland. If Ireland had its own flexible currency, what would happen to the Irish exchange rate? Could this help Ireland to get out from the recession and to reduce the default risk? (4 points) 21

22 Question 8 Given that the Irish central bank cannot conduct independent monetary policy, the Irish government is considering the use of fiscal policy. Let us analyze the effects of both a fiscal contraction and of a fiscal expansion through the lens of our model. Start from a situation where Ireland is in a recession due to a demand shock, so that Y 0 < Y*. Assumptions throughout the exercise: Use version 2 of the SRAS. Also, assume that in response to a change in G, people do not expect either a change in future taxes (i.e., PVLR does not change) or an increase in default risk. a) What happens in the short run if the government cuts government spending (reduces G)? Represent graphically the AD-AS and IS-LM models. What happens to Y, P and r? Why? (4 points) Y P r SRAS LM P 0 r 0 AD IS Y 0 Y* Y 0 Y* 22

23 b) What happens in the short run if the government increases government spending (increases G)? Represent graphically the AD-AS and IS-LM models. What happens to Y, P and r? Why? (4 points) Y P r SRAS LM P 0 r 0 AD IS Y 0 Y* Y 0 Y* 23

24 c) What happens to the government deficit under the policies in (a) and (b)? Suppose the policy in (b) leads to an increase of the government deficit: is it reasonable to assume that this will have no effects on default risk? How does this observation change your view on the fiscal policy options of the Irish government? Which policy would you advocate to the Irish government? (4 points) 24

25 TEST GRADE BREAKDOWN Question 1: (16 points total) Question 2: (16 points total) Question 3: (8 points total) Question 4: (12 points total) Question 5: (16 points total) Question 6: (20 points total + 4 extra) Question 7: (16 points total + 4 extra) Question 8: (12 points total) Total (out of extra) 25